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There is
regularly talk about the Fed (or Treasury) devaluing the US dollar, but how
do you devalue something that doesn't have a fixed measurement? Specifically,
what would the Fed/Treasury devalue the dollar against and how would they go
about it? In a recent interview with Eric King, Jim Rickards
posits that the Fed could bring about a general dollar devaluation by using
its open market operations to bid up the gold price, the idea being that devaluing
the dollar against gold would scare people out of dollars and thus cause a
reduction in the dollar's purchasing power. Would this work?
Well, if the Fed
started bidding up the gold price it would definitely scare a lot of people,
but by itself it couldn't bring about a sustained reduction in the dollar's
purchasing power. To explain why we first need to quickly revisit the
over-used concept of money "velocity".
When people talk
about a change in money velocity what they really mean is a change in money
demand. As is the case with the values of all economic goods, the value of
money is influenced by changes in both supply and demand. For example, an
increase in the supply of money wouldn't lead to a fall in the value of money
if it were offset by an equivalent increase in the demand for money (often
described as a reduction in money "velocity"). For another example,
a reduction in the demand for money (often described as an increase in money
"velocity") could bring about a reduction in money purchasing power
(a general increase in prices) even if there were no change in money supply.
However, whereas economic goods other than money are often subject to
permanent changes in demand that are separate from (that is, not caused by)
changes in supply, if the money supply is stable then changes in money demand
will almost always be temporary. Consequently, it is not possible for a
currency to experience hyperinflation, and it is extremely unlikely that a
currency could experience a large and sustained reduction in its purchasing
power, in the absence of a large increase in its supply.
The implication
of the above is that the Fed couldn't cause a sustained devaluation of the
dollar by scaring people into spending more dollars. There would also have to
be a large expansion in dollar supply. In the absence of greater dollar
supply, an economy-wide increase in prices couldn't be sustained because it
would lead to a shortage of money.
The historical
episodes of hyperinflation that we know of consisted of rapidly falling money
demand alongside rapidly rising money supply. In general terms, what tends to
happen is that after many years of persistently high monetary inflation,
people begin to anticipate future monetary inflation. That is, people begin
to factor the effects of the expected future increases in the money supply
into today's prices, causing prices to rise faster than the money supply.
This creates a perceived shortage of money, which the central bank addresses
by boosting the money supply. But this only reinforces the public's fears of
future currency depreciation, so prices begin to rise even faster. The
feedback loop continues until the currency becomes completely worthless or
until the central bank stops the expansion of the money supply.
With the above in
mind it can be seen that the Fed could not possibly engineer a sustained
GENERAL rise in prices by devaluing the dollar relative to gold. Absent an
increase in the money supply, a sustained increase in prices in one sector of
the economy would have to be offset by a fall in prices somewhere else in the
economy. Devaluing the dollar relative to gold while leaving the money supply
unchanged would simply transfer wealth to gold owners and the gold mining
industry, which we suspect would not fulfill the wishes of those in power.
With the above in
mind it can also be seen that a general devaluation of the dollar WILL occur
if the Fed continues to ramp up the supply of dollars. The effects of the
supply increase on money purchasing power (the general price level) can be,
and often are, temporarily counteracted by increased demand for money, but if
the money supply continues to increase then prices will eventually follow. Of
course, as we've discussed in many previous commentaries prices will never
follow in a uniform manner. Instead, some prices will respond earlier and
more vigorously than others.
Steve Saville
www.speculative-investor.com
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